1 The Origins and Extent of the Crisis
Th frclsur crisis facig th Uitd Stats tda did t cm ut f whr. It is thutcm f plic chics ad priat dcisis datig back mr tha a dcad. Ab
all, it arose from the creation of the subprime lending industry that emerged from changes
i th acial wrld durig th 1990s. Althugh a full dscripti f that idustr ad itsris ad fall wuld ll a bk, a shrt riw will st th ctxt fr this papr.
The Rise and Fall of Subprime Lending
Th ida bhid subprim ldig is a simpl . Histricall, hmburs dd gdcrdit bfr ldrs wuld ffr a mrtgag. Ths mrtgags wr mad aailabl at asigl r “prim” itrst rat, with l mdst ariatis. Th subprim ldig idustr
emerged to provide loans to borrowers with poor credit who could not qualify for prime
las. Basd th prpsiti that ths brrwrs ar highr risk, subprim las carrhighr itrst rats tha prim las.
This idustr wuld t ha grw, hwr, writ t fr dramatic chags i th acial wrld, icludig:Grwth f crdit scrig basd acial mdls; this allwd rms such as Fair Isaac ad C. (FICo) t dis sigl crdit scrs fr brrwrs, which claimd tprdict th risk f makig a la t th brrwr;Th ucuplig f hm ldig frm th thrift ad bakig sctrs thrugh bak c
-solidation and restructuring, and the growth of independent mortgage companies and
brkrs;Scuritizati f mrtgag dbt b Wall Strt rms, which cratd istmt pls b
bundling mortgages together and selling them on worldwide capital markets to inves-
trs; adTh all but isatiabl dmad frm istrs fr highr ild istmts, dmad that
was unmet as a result of low, long-term interest rates worldwide on traditional invest-
mt hicls.Sic th 1990s, mrtgag brkrs ha packagd mrtgags fr th acial istitutisthat prid th fuds. Ths istitutis i tur budld mrtgags tgthr, sllig thm
to Wall Street investment banks, which aggregated them into marketable securities and
sld thm i shars t istrs.
Th istmt bakrs hird trusts t hld th fudsad thr rms, kw as sricrs, t maag th mrtgags i th pl bhalf f thistrs. Ths sricrs pla a critical rl i th frclsur crisis.I thr, this was a ratial sstm. I practic, hwr, thr was a grat dal wrgwith it. Th ti that, istad f aidig risk, culd simpl rais th cst th basis
of the risk involved, coupled with the demand for high-yield investments, set off a raceamong brokers and lenders to create the most mortgages at the highest possible interest
rats. This was curagd b ldr’s us f yild Sprad Prmiums, which ga brkrshighr cmmissis fr makig highr itrst, riskir las.T mt dmad frm istrs fr still highr ilds, brkrs ad ldrs cam up withicrasigl igius was t qualif mr burs ad mak mr las. Th ffrd ad
justabl rat mrtgags (ARMs) with “xpldig” itrst rats, which startd ut with a lwitrductr r “tasr” rat that latr skrcktd, usuall aftr tw ars. Athr prductwas “ dc” las, mrtgags mad withut rquirig brrwrs t dcumt thir icmr thr bligatis, at highr itrst rats. othr “xtic” mrtgags icludd ga
ti amrtizati mrtgags ad s-calld opti ARMs, a frm f adjustabl rat mrtgag
in which borrowers could choose—within certain bounds—how much or how little to pay on
thir mrtgag ach mth. All carrid itrst rats far ab what prim ldrs chargdcustmrs with bttr crdit. Aftr 2003, gratr umbrs f subprim las wr ithr